A derivative is an asset whose value is derived from an underlying asset like a stock or currency. Derivatives are used for speculation (to take on risk) or hedging (to avoid risk).

Financial derivatives used today are:

Foreign currency futures

Currency options

Interest rate swaps

Cross currency interest rate swaps

In this chapter we focus on the fundamentals of their valuation. Many institutional traders have lost money speculating in these assets. They should be used with caution.

Foreign currency futures:

This is an alternative forward contract that calls for future delivery of a standard amount of foreign exchange, at a fixed time, place, and price. In the U.S. the most important market is the International Monetary Market (IMM) of Chicago, a division of Chicago Mercantile Exchange.

Take Mexican peso futures for example. Each contract is for 500,000 pesos, which is the notional principal. Trading must be done in multiple units of this amount. The exchange rate is reported as dollars per Mexican peso. Contracts mature on fixed dates, in the example we gave, on the third Wednesday of January, March, April, June, July, September, October or December. Contracts are traded on the second business day prior to Wednesday.

Unlike forward contracts, the trading of futures requires the purchaser to deposit a sum as an initial margin or collateral. In addition a maintenance margin is required. The value of the contract is marked to market meaning profits and losses are settled at the end of each trading day. If there is a loss, the maintenance margin is used to make up for that loss.

If a speculator buys a futures contract, they are locking in the price at which they must buy that currency on the specified future date and if they sell a futures contract, they are locking in the price at which they must sell that currency on that future date.

Short position occurs the following way. If a speculator believes the Mexican peso will fall in value versus the U.S. dollar by March, she could sell a March futures contract, taking a short position (sell high, buy back low). By selling a March contract, the speculator here locks in the right to sell 500,000 Mexican peso at a set price. If the price falls as she expects by March, she makes a profit.

Assume the speculator here sells one March contract at $.10958/MXN. Profit or loss can be calculated in the following way:

Value at maturity = -Notional principal * (Spot-Futures).

If the actual spot value on March turns out to be $.09500/MXN, the value of her position is.

Value = -MXN500,000 * ($.09500-$.10958) = $7,290.

Long position occurs the following way. If a speculator believes the Mexican peso will gain in value versus the U.S. dollar by March, she could purchase a March futures contract, taking a long position (buy low, high, sell high). By buying a March contract, the speculator here locks in the right to buy 500,000 Mexican peso at a set price. If the price rises as she expects by March, she makes a profit.

Assume the speculator here sells one March contract at $.10958/MXN. Profit or loss can be calculated in the following way:

Value at maturity = Notional principal * (Spot-Futures).

If the actual spot value on March turns out to be $.11000/MXN, the value of her position is.

Value = -MXN500,000 * ($.11000-$.10958) = $210.

Currency Options:

A foreign currency option is a contract that gives the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). "..but not the obligation means that the owner of an option possesses a valuable choice.

The buyer of an option cannot lose more than what he pays for the option.

There are two types of options: A call is an option to buy foreign currency; and a put is an option to sell foreign currency.

The buyer of an option is called the holder, and the seller of an option is called writer or grantor.

Every option has three different price elements: (1) the exercise or strike price,the exchange rate at which the foreign currency can be purchased (call) or sold (put); (2) the premium, the cost, price, or value of the option itself; and (3) the underlying or actual spot exchange rate in the market.

An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.

A European option can be exercised only on its expiration date, not before.

The premium or option price is the cost of the option, usually paid in advance by the buyer to the seller. In the over-the-counter market, premiums are quoted as a percentage of the transaction amount.

An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).

An option that would be profitable, excluding the cost of the premium, if exercised immediately is called in-the-money (ITM).

An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is called out-of-the-money (OTM).

Foreign Currency Markets:

Exchange-traded contracts are appealing to banks, speculators, and individuals who do not normally have access to the over-the-counter market.

Over-the-counter (OTC) options are most frequently written by banks for U.S. dollars against British pounds sterling, Swiss francs, Japanese yen, Canadian dollars, and the euro.

The main advantage of OTC options is that they are tailored to the specific needs of the firm. The buyer must assess the writing bank's ability to fulfill the option contract. The financial risk associated with the counterparty is an increasing issue in international markets as a result of increasing use of financial contracts like options and swaps by MNE management.

Options on the physical (underlying) currency are traded on a number of organized exchanges worldwide, including the Philadelphia Stock Exchange (PHLX) and the Chicago Mercantile Exchange.

Exchange-traded options are settled through a clearinghouse that the buyers do not deal directly with sellers.

Buyer of a Call:

Options differ from all other types of financial instruments in the patterns of risk they produce. The option holder has the choice of exercising the option or allowing it to expire unused. The owner may exercise when it is profitable, or may walk away with a loss never greater than the premium paid.

For example, assume that the currency speculator purchases the August call option on Swiss franc (please refer to Exhibit 8.2 on page 209). The strike price is 58.5 ($0.5850/SF), and the premium is $0.005/SF. The speculator will not exercise his option at all spot rates below the strike price of 58.5. At tall spot rate above the strike price of 58.5, the speculator may choose to exercise the option, paying only the strike price for each Swiss franc. For example, if the spot rate were 59.5 cents per franc at maturity, he would exercise his call option, buying Swiss francs for $0.585 each instead of purchasing them on the spot market at $0.595 each. The speculator may sell the Swiss franc immediately in the spot market for $0.595 each, and make a gross profit of $0.010/SF, or a net profit of $0.005/SF.

Profit = Spot Rate - (Strike Rate + Premium)

= $0.595/SF - ($0.585/SF + $0.005/SF) = $0.005/SF

Note that the break-even price of $0.590/SF is the price at which the speculator neither gains nor loses on exercising the option. At any spot price above the exercise price but below the break-even price, the gross profit earned on exercising the option and selling the underlying currency covers part (but not all) of the premium cost. Exhibit 8.3 on page 210 illustrates the profit and loss for the buyer of a call option.

Writer of a Call:

If the option expires when the spot price of the underlying currency is below the exercise price of 58.5, the option holder does not exercise. What the holder loses, the writer gains. The writer keeps as profit the entire premium paid of $0.005/SF. Above the exercise price of 58.5, the writer of the call must deliver the underlying currency of $0.585/SF at a time when the value of the franc is above $0.585. It the writer wrote the option "naked," that is, without owning the currency, the writer will now have to buy the currency at spot and take the loss.

For example, the profit to the writer of a call option of strike price $0.585, premium $0.005, a spot rate of $0.595/SF is:

Profit = Premium - (Spot rate - Strike Price)

= $0.005/SF - ($0.595/SF - $0.585/SF) = -$0.005/SF

At spot rates less than the strike price, the option will expire worthless and the writer of the call option will keep the premium earned. The maximum amount that the writer will make is limited to the premium. Exhibit 8.4 on page 212 illustrates the profit and loss for the writer of a call option.

Buyer of a Put:

The buyer of a put option wants to be able to sell the underlying currency at the exercise price when the market price of the currency drops. If the spot price of a franc drops $0.575/SF, the speculator will deliver francs to the writer and receive $0.585/SF. The speculator can now purchase francs at the spot market for $0.575 each and the cost of the option was $0.005/SF, so he will have a net gain of $0.005/SF.

Profit = Strike Price - (Spot Price + Premium)

= $0.585/SF - ($0.575/SF + $0.005/SF) = $0.005/SF

The break-even price for the put is the strike price less the premium ($0.580/SF).The buyer of a put can never lose more than the premium paid up front. Exhibit 8.5 on page 213 illustrates the profit and loss for the buyer of a put option.

Writer of a Put:

If the spot price of francs drops below 58.5 cents per franc, the speculator will exercise the option, and the writer will lose more than the premium received from writing the option ($0.005/SF), falling below the break-even. If the break-even price is above $0.583/SF, the speculator will not exercise the option, and the option writer will pocket the entire premium of $0.005/SF.

Profit (loss) = Premium - (Strike Price - Spot Price)

= $0.005/SF - ($0.585/SF - $0.575/SF) = -$0.005/SF

At spot rates greater than the strike price, the option expires out-of-money and the writer keeps the premium. Exhibit 8.6 on page 214 illustrates the profit and loss for the writer of a put option.

Option Pricing and Valuation:

Exhibit 8.7 on page 215 illustrates the profit /loss profile of a European-style call option on British pounds. The call option allows the holder to buy British pounds at a strike price of $1.70/ with 90-day maturity.

Total Value (Premium) = Intrinsic Value + Time Value

Intrinsic value is the financial gain if the option is exercised immediately. Intrinsic value will be zero when the option is out-of-the-money - that is when the strike price is above the market place- as no gain can be derived from exercising the option. When the spot rate rises above the strike price, the intrinsic value becomes positive. On the date of maturity, an option will have a value equal to its intrinsic value.

The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further and further into the money before the option's expiration.

The six basic option premium components are:

(1) Delta: Expected change in the option premium for a small change in the spot rate. The higher the delta, the more likely the option will move in-the-money.

(2) Theta: Expected change in the option premium for a small change in time to expiration. Premiums are relatively intensive until the final 30 or so days.

(3) Lambda: Expected change in the option premium for a small change in volatility. Premiums rise with increases in volatility.

(4) Rho: Expected change in the option premium for a small change in the domestic interest rate. Increases in domestic interest rate cause increasing call option premiums.

(5) Phi: Expected change in the option premium for a small change in the foreign interest rate. Increases in foreign interest rates cause decreasing call option premiums.

Interest Rate Risk:

All firms are sensitive to changes in interest rates. The single largest interest rate risk of the nonfinancial firm is debt service. The debt structure of the MNE will possess differing maturities of debt, different interest rate structures, and different currencies of denomination.

The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities. The marketable securities portfolio of the firm appear on the left-hand side of the balance sheet, and represent potential earnings or interest inflows to the firm.

Credit Risk and Repricing Risk:

Credit risk is the possibility that a borrower's creditworth, at the time of renewing a credit, is reclassified by the lender. This can result in charging fees, charging interest rates, altered credit line commitments, or even denials.

Repricing risk is the risk of changes in interest rates charged at the time a financial contract's rate is reset.

Assume the corporate borrower will decide which of the following debt strategies would be better for the corporate:

(1) Borrow $1 million for three years at a fixed rate of interest. This option maximizes the predictability of cash flows for the debt obligation. However, if the interest rates fall, they will not be able to enjoy lower interest rates.

(2) Borrow $1 million for three years at a floating rate, LIBOR +2%, to be reset annually. This strategy provides flexibility (repricing risk). It also assures three years of full funding, and eliminates credit risk. If LIBOR rates increase dramatically by the second or third year, the rate change is passed through fully to the borrower.

(3) Borrow $1 million for one year at a fixed rate, then renew the credit annually. With this option, the firm is borrowing at the shorter end of the yield of the curve. However, since the credit is renewed annually, this option may not be the best one for a firm that is financially weak.

Interest Rate Derivatives:

Interest rates have derivatives in the form of futures, forwards, options, and interest rate swap.

Interest Rate Futures:

Interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. Their popularity is from the relatively high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest rate exposures most firms possess.

The yield of a futures contract is calculated from the settlement price, which is the closing price for that trading day. For example, Exhibit 8.10 on page 219 illustrates the Eurodollar futures for two years. A March 2011 contract has a settlement price on the previous day was 94.76, an annual yield of 5.24%.

Yield = 100 - 94.76 = 5.24%

Since each contract is for 3-month period and a notional principal of $1 million, each basis point is actually worth $2,500 (.01 x $1,000,000 x 90/360).

If a financial manager were interested in hedging a floating-rate interest payment due in March 2011, she would need to sell a future, to take a short position. If the interest rates rise by March the futures price will fall and she will be able to close the position at a profit. If the financial manager is wrong, and interest rates actually fall by the maturity date, causing the futures price to rise, she will suffer a loss that will wipe out the savings derived by making a lower floating-rate interest payment than she expected.

Forward Rate Agreements:

A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal. The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date.

Interest Rate Swaps:

Swaps are contractual agreements to exchange or swap a series of cash flows. If the agreement is for one party to swap its fixed interest rate payment for the floating interest rate payments of another, it is called interest rate swap. If the agreement is to swap currencies of debt service obligation, it is called a currency swap. A single swap may combine elements of both interest rate and currency swaps.

The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment.

Currency Swaps:

The fixed-to floating-rate interest rate swap existing in each currency allows firms across currencies. The swap market does not carry the credit risk associated with individual borrowers.

The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency.

Havingcovered these topics, please answer the following:

How are futures contracts different than forward contracts?

Define taking a short position in futures contracts.

How is an option contract different than a futures contract? What is meant by the terms in-the-money, at-the-money, and out-of-the money? What is the difference between an American option and a European option?

When does it pay to exercise a call option?

When does it not pay to exercise a put option?

What is interest rate risk and what are the most prevalent sources of interest rate risk?

How can interest rate risk be managed?